How Pepsi outgunned Coke
Losing the cola wars was the best thing that ever happened to Pepsi -- while Coke was celebrating, PEP took over a much larger market.
By Katrina Brooker, FORTUNE senior writer

NEW YORK (FORTUNE) - Pepsi beat Coke in December for the first time in their 108-year rivalry, surpassing its nemesis in market capitalization. The great irony of Pepsi's rise is this: It has never sold more soda than Coke, even today.

"Pepsi's been on fire," notes Robert van Brugge, beverage analyst with Sanford Bernstein. Over the past five years its stock has risen more than a third, while Coke's has sunk 30 percent.

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Even ten years ago, it was easy to write off PepsiCo (Research) as the loser in the cola wars against Coke (Research): the proof was everywhere. The company's profits trailed those of its rival in Atlanta by 47 percent. Its value in the stock market was less than half of Coca-Cola's. Coke's CEO at the time, Roberto Goizueta, was so sure of his company's dominance that he practically dismissed Pepsi, telling FORTUNE, "As they've become less relevant, I don't need to look at them very much anymore."

PepsiCo turned its cola Waterloo into an opportunity to retrench, regroup, and ultimately outflank its old foe. Losing the cola wars, it turns out, was the best thing that ever happened to Pepsi. It prompted Pepsi's leaders to look outside the confines of their battle with Coke.

A decade ago, Coke offered investors a compelling story: a recession-resistant product inexpensive enough that consumers would buy it in good times and bad, but valued enough that they would willingly pay an extra nickel or so above what no-name brands charged.

What Coke investors didn't envision was that an emerging preference for other soft beverages --water, sports drinks -- would fracture demand. Nor did they see that the business strengths that once applied to cola would take hold across a broadened soft drink and snack-food market -- a market that Pepsi, and not Coke, dominated.

"They were the first to recognize that the consumer was moving to noncarbonated products, and they innovated aggressively," observes Gary Hemphill of Beverage Marketing.

PepsiCo embraced bottled water and sports drinks much earlier than its rival. Pepsi's Aquafina is the No. 1 water brand, with Coke's Dasani trailing; in sports drinks, Pepsi's Gatorade owns 80 percent of the market while Coke's Powerade has 15 percent.

Throughout the past five years under CEO Steve Reinemund, the company has deftly moved with every shift in consumer tastes. "He's thinking about what the products should look like in the future," says Victor Dzau, a director of PepsiCo.

Beyond beverages

But Pepsi's strongest business lies outside drinks altogether. Over the past ten years, the Frito-Lay division -- which seems like it sells practically every chip in every store in the country -- has become a powerhouse, controlling 60 percent of the U.S. snack-food market. So strong is Pepsi in this arena, in fact, that many investors no longer judge it by how it stacks up against Coke.

"Most people think of Pepsi and Coke fighting it out," observes Eric Schoenstein, an analyst at Jensen Investment Management, which owns shares of both. "But we don't see it that way. Pepsi isn't really a beverage company anymore: It's a food company that also sells beverages."

The company's big push now is getting all its different fiefdoms to work together, especially in sales and marketing campaigns. As this year's Super Bowl looms, supermarket shoppers will see in-store displays that tout watching the game while munching Lays chips and slurping on a Diet Pepsi.

PepsiCo needs that growth as it faces a toughening economic climate. Nonetheless, over the past five years Pepsi has demonstrated an ability to ride out business cycles and sustain its results: Net profits have climbed 50 percent, sales are up 33 percent. Since 2002, sales and earnings per share have grown every quarter year-on-year.

The company boasts 16 brands that bring in more than $1 billion each a year in revenue. Over the next five years, operating profits are expected to rise by 7.5 percent per year, compared with 5 percent for the rest of the industry and 6.5 percent for Coke, according to Sanford Bernstein.

The irony of Pepsi's success is that despite how far it has come out of the cola trenches, inside the company the primary competitive driver is still Coke. Ask any employee who the enemy is and the answer comes quick: "Every one of them will say Coke," says consultant Ken Harris, who's worked closely with Pepsi.

Coke may no longer be the real competition, but for the soldiers of Pepsi, it's still a very useful enemy.

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